Understanding Debentures and Bonds

Investors looking for regular fixed income through the payment of interest can invest in debentures and in bonds. They are both fixed income instruments put out by borrowers wishing to raise capital for various business purposes.

In finance, a bond is a debt security, in which the approved issuer owes the holders a debt which they are obliged to repay at a later date. This later date is termed the maturity. The obligation is to repay both the principal and interest (the coupon). It is simply a loan in the form of a security with different terminology. Bonds and debentures enable the issuer to finance long-term investments with external funds.

So what are the differences?

Debentures and bonds are debt instruments with different types of risk exposure. Generally bondholders are secured by access to the underlying asset in case of default by the issuer. In contrast, debentures are unsecured and holders do not have recourse to assets if the debenture issuer defaults.Debentures are backed only by the general creditworthiness and reputation of the issuer.

A bond price fluctuates according to the market interest rates. If the interest rates go down the value of the bond goes up whereas the reverse applies if the interest rates rise. The varying price becomes important when the bond is being traded but not much of a concern if holding to maturity. Liquidity is possible during the term of the investment, unlike debentures which do not tend to be traded. Debentures may be broken at a penalty rate.

The interest rate offered on bonds depends on a number of factors, including the maturity and the credit rating of the issuer. Normally the longer the time frame of the bond, the higher the offered return. The better the credit rating of the issuer, the lower the interest rate that is offered. Interest rates on debentures tend to be higher to reflect the higher risk.

The main International Rating Houses for bonds are Moody’s, S&P and Fitch. They each have their own rating scale but are very similar using ‘A A A’ as the top tier. When you were at school you no doubt thought a B was not too bad, in fact pretty good, but when applied to a bond or debenture this is not the case. This is more of a speculative rating meaning there is a one in five chance of default over five years. It is important to note that ratings will not always predict default perfectly. Failure is a possible outcome for even a highly rated institution. Bond issues come with a rating whereas some companies offering debentures may apply to be rated but this is not always the case.

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